Selling Specific Lots
IRS Publication 550 explains the process of how to identify specific lots to your broker for sale, should you so desire.
The default method is First-In-First-Out (FIFO), which is not always the most tax advantageous method. Nor is FIFO necessarily the way a Trader would trade.
For instance, a Trader has a planned position in a particular underlying but wants to take a different position during a specific event, such as earnings. The trader initiates a cash-secured short put (Naked Put) in anticipation of a sudden increase in the share price. That does not occur and the Trader is assigned the shares. Since that was not a part of the Trader’s overall trading plan for that underlying, the shares are either sold or a covered call position entered. The shares are called away but the Trader continues the other positions.
In this example, the Trader does not want the other shares owned to be deemed sold on a FIFO basis, thus maintaining this trade as independent of the others. Therefore, the specific lots must be identified to the broker.
As reflected in TC Opinion 2014-14, taxpayers cannot rely on IRS Publications for tax return positions which essentially negates any guidance provided from Pub 550. So what can they rely upon?
The Internal Revenue Code and Regulations as well as Case law.
Therefore, what do the Code, Regulations and specific Case law have to say about specific lot identification?
Well, not much as it turns out.
If stock is left in the custody of a broker, adequate identification is made if, at the time of the sale or transfer, the taxpayer specifies to the broker or agent the particular stock to be sold or transferred and, within a reasonable time thereafter, the broker sets forth such specification in a written confirmation. Reg Sec 1.1012-1(c)(3)(ii)
IRS Notice 2011-56 states the “conventions” noted in IRC Sec 1012 for determining stock basis. The legislative history identifies these “conventions” as First-In First-Out (FIFO), specific identification and average basis. Average basis is typically used with investments in Regulated Investment Companies (RICs) otherwise known as mutual funds.
IRS Publication 550 explains that if the shares can be adequately identified, the basis of the shares sold is the cost of the shares specifically identified.
However, Pub 550 also defines “adequate identification” as identifying the shares purchased on a certain date for a certain price.
However, in the context of the broker holding the securities, Pub 550 also explains how this is accomplished:
Communicate to the broker the shares to be sold
Receive written confirmation from the broker acknowledging same
Quite frankly, in the world of electronic/online trading this process is painfully inadequate.
In Miller v Commissioner, 80 Fed (2d) 219 the following procedure was determined:
Specific certificates delivered determines basis
Designation by the the taxpayer to the broker even if the certificates delivered do not correspond to the instructions, and
FIFO controls in absence of the foregoing
In Fuller v Commissioner, 81 Fed (2d) 176 the court held that the taxpayer’s instructions to his assistant to ascertain the highest cost shares after a 5-for-1 stock split and to sell those shares was adequate identification when the appropriate records were made on the taxpayer’s records.
Therefore, in my opinion, case law - albeit old (Fuller was decided in 1936) - supports the contention that the taxpayer can adequately identify shares sold if supported by his/her records.
Further, I would consider this an aggressive interpretation of Fuller and would suggest making every effort to coordinate your trading of specific lots with your brokerage firm.
Thus, if you keep adequate records and details of every trade, those records should support the “adequate identification” requirement standard.
In 1936 there were no laptops or tablets to jot notes into or spreadsheets to keep detailed record of trades. Apparently, the detailed records in a “green-sheet” ledger supported the taxpayer’s position.
Without being to blatantly obvious, the basic version of the Option Traders Template®, the Trader®, should satisfy the “adequate identification” requirement.
Take a look at the Trading tab demos to see if it will work for you!!